For a financial advisor, floating rate notes can be useful when you want to reduce interest rate sensitivity without abandoning bonds altogether. At the same time, these securities are not a cure-all. They do not solve every risk in your fixed income sleeve.
In this article, Wealth Professional Canada will explore what floating rate notes are and how you can think about their place in your clients' portfolios. We'll discuss what to watch for when you recommend them to your clients. You can also find the latest news on floating rate notes when you scroll to the bottom of the page!
A floating rate note (FRN) is a fixed income security where the interest payments change over time. Instead of paying a steady coupon from issue date to maturity, a floating rate note pays interest that resets at set intervals based on a reference rate plus a spread.
Floating rate notes usually sit in the short- to medium-term part of the curve. Many issues mature in roughly two to five years, similar to shorter conventional bonds. However, the coupons do not stay fixed. They reset on a schedule that can range from monthly to quarterly or even longer.
From a legal standpoint, floating rate notes are debt instruments. They can be issued by:
The common feature across all of these is that the rate you earn is not locked in for the life of the security. It moves in line with the chosen benchmark plus the agreed spread.
A bond whose coupon payments move up or down with a reference interest rate, helping investors reduce interest rate risk.
A Floating Rate Note (FRN) is a debt security that pays interest at a variable rate, typically quoted as a reference rate (for example, SOFR or a similar benchmark) plus a fixed spread. As the benchmark rate changes, the coupon on the FRN is periodically reset, so coupon payments adjust over time.
Because the coupon adjusts with market rates, the price of an FRN tends to be less sensitive to interest rate movements compared with a traditional fixed-rate bond.
Why investors use FRNs: To limit interest rate risk while still earning bond income, especially in environments where rates are expected to rise.
The FRN coupon (solid line) moves with market rates, while the fixed-rate bond coupon (dashed line) stays flat. When rates change, the FRN's coupon is periodically reset, so its price typically stays closer to par than a comparable fixed-rate bond.
Reference rate (e.g., overnight benchmark), fixed spread, coupon reset dates (e.g., quarterly), and a stated maturity date.
Want to be a top financial advisor in Canada? You need to guide your clients when investing in floating rate notes. Review if this investment type fits their goals and risk tolerance.
When the issuer brings an FRN to market, the term to maturity is set in advance, along with:
Suppose a Canadian bank issues a three-year floating rate note. The terms might say that the coupon will reset every three months at a short-term money market rate plus a fixed number of basis points.
Each time the reset date arrives, the coupon for the next period is recalculated based on the current level of the benchmark. If the reference rate has risen since the last reset, the coupon for the next period will be higher. If the reference rate has fallen, the coupon will step down.
The spread itself does not change. It stays locked for the life of the note and is meant to compensate investors for the issuer's credit risk and for any other features, such as subordination.
This reset feature has two important effects:
Your clients do not receive a flat payment throughout the life of the security. As central banks move policy rates and money market benchmarks respond, the coupon on a floating rate note follows.
In a rising rate environment, that can lead to higher payments over time. In a falling rate environment, the opposite is true.
Because the coupon adjusts on a regular schedule, the market does not need to discount a long stream of fixed payments in the same way it does with a traditional bond. The effective duration is closer to the time remaining until the next reset, rather than to the final maturity date.
That usually means smaller price moves when rates change, especially compared with longer duration, fixed coupon bonds. Floating rate notes still trade in secondary markets, and their prices can move with changes in credit spreads and risk sentiment.
In the corporate market, an FRN behaves like any other bond with credit exposure. It can benefit from spread tightening and suffer when spreads widen, even while the coupon itself is adjusting with short-term rates.
Whether floating rate notes deserve a place in your clients' portfolios depends on what you are trying to achieve. Fixed rate bonds lose value when rates move higher, since their coupons become less attractive relative to new issues. With FRNs, the coupon steps up as the reference rate increases.
This can help keep the price closer to par while also lifting income over time. The lower duration of these securities can reduce the hit from higher yields, especially compared with long-dated, fixed rate bonds.
Floating rate notes can give your clients a way to stay invested in fixed income while limiting the risk that they lock in a coupon that later looks too low. For example, a corporate issuer that funds with floating rate debt avoids committing to a long-term fixed rate that might turn out to be expensive.
On the other hand, your clients receive coupon payments that adjust with the market, instead of a static rate that could lag new issues. It is also vital to remember that floating rate notes are different from inflation-related bonds.
An FRN is tied to short-term interest rates, not to an inflation index. There can be periods when inflation is high while benchmark rates stay restrained. In that case, coupons on floating rate notes can lag the increase in living costs.
To simplify, they can reduce some interest rate risk, but they do not guarantee protection for purchasing power.
Floating rate notes can reduce certain risks in a fixed income allocation, but they also introduce their own challenges. Here are five examples of the risks of FRNs:
This risk is direct. The same mechanism that helps in a rising rate environment becomes a headwind if rates move lower. When the reference rate drops, coupon payments on floating rate notes follow. Your clients might see their income shrink over time, even if the note's price holds up.
For investors who want a steady income profile, that variability can be uncomfortable. While the duration of an FRN is usually shorter than that of a similar maturity fixed coupon bond, it is not zero.
There is still some sensitivity to changes in yields between reset dates, and to shifts in expectations about future policy moves. The shorter the reset period, the smaller that effect, but it does not disappear entirely.
Like any bond, a floating rate note depends on the issuer's ability and willingness to pay interest and principal. Government-issued FRNs, where available, tend to have very low default risk. Corporate floating rate notes, including those from banks and non-financial issuers, carry credit risk.
The spread on an FRN is meant to compensate investors for this credit risk. If the market starts to worry more about an issuer's financial position, that spread can widen.
The price of the note can fall even if the reference rate is stable or rising. Your clients can also face losses if a default or restructuring occurs.
Another risk comes from the fact that each floating rate note is tied to one reference rate. In practice, there are several short-term benchmarks in use. If the rate used for the note moves differently from other rates in the market, your clients can be exposed to basis risk.
For example, a portfolio might contain FRNs linked to one benchmark, while funding costs or alternative investments move with another. If those benchmarks diverge, the income and valuation of the floating rate note might not line up with other parts of the portfolio in the way you expect.
Floating rate notes can be a poor fit for investors who need dependable, level cash flows. Retirees and others who fund living expenses from portfolio income often want schedules they can plan around.
Because FRN coupons adjust every reset period, there is no stable payment level your clients can count on. One quarter might look strong if short-term rates are rising. The next year might bring much lower coupons if policy rates are cut.
If your clients use distributions from bond holdings to pay regular bills, this variability can create strain.
Finally, floating rate notes are sometimes mistaken for inflation hedges. While higher inflation can lead central banks to raise short-term rates, the link is not automatic or immediate. It is entirely possible to have high inflation with low policy rates, or to see benchmark rates increase in a setting where inflation stays subdued.
Because FRNs are tied to interest rate benchmarks rather than price indices, they do not guarantee that income will move in line with the cost of living. In some scenarios, they can lag inflation and reduce real purchasing power for your clients.
Floating rate notes can reduce some risks in a fixed income allocation, but they also introduce their own.
Floating rate notes shift some risk away from duration, but other sources of risk remain, including credit quality, benchmark choice, income variability, and the gap between interest rates and inflation.
Floating rate notes give you another way to help your clients manage interest rate risk in the fixed income portion of their portfolios. However, FRNs are not suitable for every situation as we've explored earlier.
Coupon payments move around, and this makes them less useful for funding steady, predictable expenses. They still carry credit risk, especially in the corporate market. Plus, they do not guarantee protection from inflation. The choice of benchmark also introduces its own set of considerations.
With these in mind, a clear discussion can be beneficial to your clients in realizing both the upsides of floating rate notes as well as the risks. From there, they can decide whether these fixed income securities deserve a spot in their long-term strategy.
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